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| Warren Buffett: Oracle of Omaha, Patron Saint of Value Investing |
The Value Investor Conference–held in Omaha, Nebraska just around the time of the Berkshire Hathaway BRK-B annual meeting–is well-attended by the Illuminati of value investing. At the 2012 conference, the organizers invited professor Aswath Damodaran, one of the world’s foremost experts on valuing companies to give a talk.
The talk he gave, entitled Where is the ‘value’ in value investing? was meant to be controversial and boy, was it! For example, in the presentation (which I have posted on the IOI Resources tab), one of his slides refers to the three Rs of value investing, characterizing value investors as Rigid, Righteous, and Ritualistic. Working closely with self-identified value investors for the last decade, I have seen plenty demonstrations of all of these Rs at work, so got a good chuckle from reading through his presentation.
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| Aswath Damodaran, NYU professor and cruel doubter of Value Investing |
A paper that Damodaran published at the same time entitled Value Investing: Investing for Grown Ups? (also posted on the IOI Resource tab) is lower in shock value but long in information. It is an in-depth investigation of what it means to be a value investor, what analytic tools are used in value investing, and what sub-categories of value investor exist.
Reading through this paper was informative and helpful to me, especially his summary of the valuation method preferred by Warren Buffett, the modern-day saint of Value Investing.
To be quite honest, I have always felt a little uncomfortable with the sycophantic fawning over Buffett by value investors and the press, and in reaction to this, have made a point of not reading every word he has ever written or buying any of the numerous hagiographies written about him. I think he is a great investor and appreciate his insight into companies, but I have always preferred to try to innovate rather than emulate, so have never studied his valuation method closely.
Much to my surprise, Buffett’s approach to valuation and investing–as summarized by Damodaran–is quite close to the IOI method (or vice versa…). I found particular and striking similarities in three areas:
- Preferred metrics for “earnings”
- Attitude toward risk
- Liberal use of options in investing
Earnings
According to Damodaran (pp. 10-11 of his paper), Buffett’s preferred measure of earnings–which he calls “owner earnings”–is calculated as follows:
Owner Earnings = Net Income + Depreciation & Amortization – Maintenance Capital Expenditures
For readers of the Valuation Notes published on this blog, this should sound very similar to what I call in my book “economic profit” and which I equate to the wealth generated by a company:
Economic Profit = Cash Flow from Operations – Maintenance Capital Expenditures
Since Cash Flow from Operations’s two biggest inputs are Net Income and Depreciation & Amortization, it turns out that the two definitions–owners earnings and economic profit–are very close. Indeed, when I am valuing a company and analyzing economic profit, I spend a good deal of time looking at the components of Cash Flow from Operations to make sure that all of what is there is really economic profit that can flow through to owners. (For one example of my nixing a big part of a company’s CFO, take a look at the post on June 10,
Amazon’s Riddle: When is Cash Flow from Operations not a Cash Flow.)
Buffett likes simple companies, and I think one of the reasons is because simple companies usually have little in the way of odd, non-cash charges or credits that can muddy the water regarding how much wealth a given company is creating on behalf of its owners. These kinds of companies are also easiest for the IOI valuation method, of course.
Risk
Orthodox ideas of risk in the academic world are based on price variance. Because most people in the industry are trained by orthodox professors, this view has bled heavily into industry as well. Ask any Wall Street professional or hedge fund analyst how they define risk, and most will recite back the formula from the Capital Asset Pricing Model (CAPM).
The problem is that this CAPM view of risk is nonsensical for anyone who believes there are exploitable mispricings in the market–in other words, to any active investor.
CAPM is based on the principles of the Efficient Market Hypothesis, and the EMH holds that the present market price of a stock represents the true value of the shares. If the market price represents the true value, clearly, there is absolutely no point in looking for exploitable mispricings.
A value investor is certain that exploitable investment opportunities exist, so to be intellectually honest, must abandon a CAPM conception of risk because it implies that exploitable investment opportunities do not exist.
Abandoning the CAPM view of risk means taking a different approach to the “discount rate” used to estimate the present value of projected future cash flows.
Indeed, it turns out that Buffett does take a very different approach to the issue of discount rate than that taught in graduate schools of business worldwide: he uses the risk-free rate (i.e., the rate on U.S. Treasury Bonds). This bit of financial blasphemy makes a good deal of sense if one thinks about the value of a stock over a very long holding period.
Ove
r short holding periods, stocks are very risky instruments indeed, as anyone who has invested in the last 15 years knows. However, over longer time frames, equities have consistently trended upward. In other words, if one takes a long enough view, the starts, stops, and crashes of the stock market even out to provide a very nice, consistent positive return. In other words, there is little long-term structural risk in the market.
Instead of the risk-free rate, the IOI valuation method uses a fixed discount rate of 10% in most cases. Ten percent comes for several reasons: 1) humans have ten fingers, so our mathematical system makes it easy to calculate in base-10, 2) since the mid-1920s, the equity market has generated compound annual returns of around 10%.
The numbers IOI uses differs from the numbers Buffett uses, but the underlying principle and reasoning regarding risk are the same.
Options
Buffett is famous for having called the complex derivatives that brought down Lehman Brothers, Bear Sterns, and very nearly the entire US financial system “financial weapons of mass destruction.” Many people take this to mean that he hates the use of derivatives of all sorts, options included.
This impression, though, could not be further from the truth. One does not even need to reference the famous transactions he made on behalf of the Berkshire portfolio to
sell puts on the S&P 500 or
buy call options on Goldman Sachs GS (these were actually not straight calls but bonds with attached calls–warrants), but simply note that his main investment asset is an insurance company: GEICO.
Insurance companies are, by definition, solely dedicated to selling put options. GEICO, like any insurance company, receives premium and agrees to indemnify the customer from financial hardship associated with a loss in value of an underlying asset–precisely the definition of a put option.
Conclusion
Warren Buffett certainly does not read the IOI blog or spend any time on the
IOI website. On the other hand, I don’t spend any time reading what he writes either! Nice to know, though, that IOI valuation methodology shares so many fundamental similarities to the method Buffett uses in his own investments.
